Trading CFDs: some pointers

Published September 2, 2010

By R SIVANITHY


AS REPORTED in this column some weeks back ('How well do investors understand CFD risks?' BT, July 22), regulatory antennae in Australia were recently raised when the authorities found from a survey that a large number of retail players in the contracts for differences (CFD) market were ignorant of the risks associated with the instrument.


A study was then launched by the regulators and it remains to be seen what measures, if any, the authorities Down Under will impose on the CFD industry to address the concerns the survey raised.

It also remains to be seen if the situation is similar in Singapore, where CFDs are said to be one of the fastest-growing segments in the local financial market.

Leverage effect

Until any such survey is conducted, though, there are nevertheless several points of interest that prospective and current CFD investors might wish to consider when dealing with this instrument.

First and most obvious is to gain a thorough understanding of all the facets of CFDs and the leverage effect they can offer via the margin feature - both on the upside and downside.

In this regard, it's worth noting the commissions to be paid and the interest or funding charges for long positions. (Conversely, note that interest is earned for short positions).

Second is to compare the features of CFDs with other leveraged products such as structured warrants before deciding which instrument is best for individual needs.

For example, warrants have a short-term, finite lifespan and require knowledge of how volatility works but are traded on the Singapore Exchange (SGX), whereas CFDs theoretically have an unlimited lifespan and need not require volatility calculations but are not - at least not yet, in Singapore's case - traded on SGX.

Third and perhaps most importantly, once the investor has decided to take the CFD plunge, is to select an appropriate CFD provider. This is the counterparty in a CFD trade - the financial entity with whom the CFD account is opened - and so this means it is vital to ask certain questions before setting up an account and commencing trading.

First, it's best to scrutinise the account-opening forms to see if the provider highlights the risks associated with CFDs or relegates these to the fine print. This might offer clues as to how the provider conducts its business and whether it is a long-term player who wishes to forge a lasting relationship with clients or otherwise.

Second, education and training, without which it would be impossible to trade CFDs meaningfully. In Australia's experience mentioned earlier, the survey found that in some cases, even sales personnel themselves were not fully conversant with the intricacies of CFDs.

In this regard, it would be worthwhile checking if the provider invests meaningful resources training and educating all its customers - and staff. Again, this would provide some indication as to its long-term commitment to its business.

Third, it's worth finding out if the provider force-sells clients' losing positions if these positions become under-margined, to prevent such clients from losing too much money.

In CFD trading, the effect of leverage means that losses can be hugely magnified and thus not confined to the initial capital outlay (which typically is just a fraction of the price of the underlying assets). If positions are not monitored constantly or if markets 'gap' unexpectedly (that is, open with an unnaturally large gap between current and most recent prices), the consequent loss can be painfully large if not closed out quickly.

Financial strength

Providers are, of course, under no obligation to exercise discretion and close out losing positions, but some are known to take the initiative and try to limit a customer's loss by acting of their own accord.

Finally, the provider's financial strength. Just like trading in any instrument, there is a risk of loss connected to the financial standing of the broker/ bank/warrant issuer/CFD provider that is providing the service.

Prospective customers should therefore perform their own 'due diligence' on the provider's background before signing on the dotted line.

Finally, note that CFDs are not for everyone. They are inherently riskier than ordinary stocks and so require a greater degree of sophistication when trading.

They are, however, a useful addition to any financial market since their presence enhances the range of products available to investors. The key, as always, is education, understanding and knowing the right questions to ask.